The response by the West to the invasion has been severe
In addition to the provision of weapons and military equipment to Ukraine, a key part of the response from the West thus far has been the implementation of sanctions. These may have surprised the Kremlin in terms of their severity, particularly when compared to those in 2014. When Russia annexed Crimea there were several rounds of sanctions which included measures such as travel bans, asset freezes, transaction bans with certain entities and restrictions on certain exports (arms, equipment for the oil industry). However the current measures go far beyond these, particularly with those targeting the financial system, in the form of SWIFT, the central bank and some major Russian banks. A key difference today is the level of cooperation between Western governments. President Putin may have hoped to see some disunity; instead the opposite has occurred with the West firmly united against Russia’s actions, sanctions having been implemented by the US, UK, EU, Australia, Canada, Japan and Switzerland.
The actions taken by Western countries now are not only substantial in their immediate effect but also have enormous longer-term ramifications: for instance, Germany’s supplying of weapons to conflict zones is a massive about-turn in its post-WWII foreign policy, and its commitment to boost its defence spending substantially to meet the 2% of GDP NATO target (up from 1.56% in 2020) a big change. It is also very significant that neutral Finland and Sweden have voiced that they are considering joining NATO. And were Ukraine to be granted immediate fast-track EU membership, as Ukrainian President Volodymyr Zelenskiy has called for, this would clearly alter the geopolitical balance of power. These decisions need to be viewed in the context of Russia’s implicit threat to go as far as using nuclear weapons in this conflict.
The conflict will be hugely damaging for Ukraine and Russia
It goes without saying that, even so, the war on its soil has a potentially vast impact on Ukraine itself. In most wars, lives are lost, including among civilians; there is huge upheaval and dislocation of the population; infrastructure is destroyed; assets lose value – and that is prior to taking into account the monetary cost of the war itself and the economic activity that is prevented from taking place as resources are diverted to the war. Arriving at an estimate of the scale of the likely losses to Ukraine is impossible at this stage, but the destruction already appears substantial.
A key question is what kind of impact sanctions will have on Russia and whether they can have an influence in dissuading Putin from further action. Clearly from the measures announced over the weekend the focus is on applying financial pressure on Russia. Two aspects stand out here: i) sanctions against the central bank and, ii), the removal of several Russian banks from SWIFT.
The sanctions on Russia’s central bank are clearly aimed at limiting its ability to circumvent the impact of other sanctions by deploying Russia’s international reserves. The most recent data puts these reserves at around $620bn. However announcements by Western governments, most prominently by the US Treasury, have now prohibited citizens from conducting any transactions with Russia’s central bank, the Russian National Wealth Fund, the Finance Ministry or the Russian Direct Investment Fund. Notably it is the first time the sanctioning of the central bank has ever been applied to a G20 country; the only previous occasions were against Iran, Venezuela and North Korea. Essentially this action prevents the use of Russia’s reserves to support the rouble, which on Monday saw it fall to a record low against the US dollar of RUB118 at one point, a 30% fall on the day. Russia’s central bank governor Elvira Nabiullina acknowledged as much: having intervened in the FX market on Thursday and Friday, she confirmed that the central bank did not intervene in the rouble’s fall on Monday due to the restrictions. Instead the central bank sought to soften the rouble’s slide by instigating a 10.5%pt hike in interest rates to 20%. It also introduced capital controls aimed at stemming a flight of capital out of the country. In a separate measure to support the currency, the Finance Ministry also told exporting companies to sell 80% of their foreign currency revenues.
The West’s second major action targeting Russia’s financial system takes aim at its ability to conduct any financial or trade transaction with the rest of the world. This takes the form of disconnecting it from the global messaging service SWIFT which facilitates trillions of dollars worth of international transactions per day. At present full details are still unavailable but the US, UK, EU and Japan have backed the proposal to remove several major Russian banks from the system. Given that some of Russia’s top banks, Sberbank and VTB, were sanctioned last week and had their access to the US financial system cut off, they may well be prime targets of the SWIFT ban. Whereas this is not a blanket ban for all Russian banks, at least for now, it will mean that any financial transaction with a Russian bank will now be much harder, limiting trade and the ability to raise finance. Major global banks such as HSBC and Société Générale have reportedly already begun cutting relationships with Russian banks.
That the war has taken place at all has wrong-footed many seasoned geopolitical observers and military experts.
A consequence of these measures has been some concern about the solvency of certain banks and the potential for bank runs. Certainly there have been reports of queues of people attempting to withdraw money in Russia. Notably the ECB’s Single Resolution Board (SRB) has already warned that Sberbank’s European operation Sberbank Europe, under the impact of sanctions and deposit outflows, is ‘failing or likely to fail due to the deterioration of their liquidity situation’ with ‘no available measures with a realistic chance of restoring’ its liquidity position – a worry that could be replicated to other sanctioned banks.
As such Russia faces a very difficult economic period ahead. Following the annexation of Crimea in 2014 Russia suffered a financial crisis and a recession causing the economy to contract by 1.7% in 2015. The impact this time is set to be much more severe. The sharp fall in the rouble will further fuel inflation, heaping additional pressure on households, a situation that certainly won’t be helped by the sharp rise in interest rates. Meanwhile the isolation of Russia from the international financial system will have a crippling impact on Russian international trade and its ability to raise external financing.
The major developed economies and markets are also impacted
The channels through which the conflict can affect the major developed economies and markets are numerous.
First and perhaps foremost, there is a humanitarian cost to the crisis as refugees flee the conflict zone. Already the UN has estimated that over 500,000 people have left the country, primarily for Poland, but also Hungary, Moldova, Romania and Slovakia among others. Sheltering and assisting them will come at a fiscal cost; and there will be calls for other nations to bear some of it and take a share of refugees too. The EU has indicated it intends to give Ukrainian refugees the right to stay and work within the EU for a period of up to three years. And the UK has announced plans to accept relatives of Ukrainians settled in the UK too.
Global financial markets have also begun to feel the effects, the reaction to the deterioration in risk sentiment being a familiar one – USD firming, government bonds rallying and equity markets weakening. However, since the invasion of Ukraine on 24 February market performance has been nuanced; certainly equity market falls have not been quite as large as may have been expected, at least thus far. Since the close on 23 February the S&P 500 is actually 2.7% up. European indices are somewhat lower: the FTSE is down 2.3% whilst Euro STOXX 50 has fallen 4.9%. The same cannot be said for Russian indices: the main MOEX index is down 24%, but notably all Russian indices have been suspended since Friday. In bond markets yields have fallen across the G7 space as safe-haven assets have been sought and market expectations for interest rate hikes have softened. 10yr US Treasury yields trade at 1.74% having exceeded 2% earlier in February, whilst Bund yields have once again returned to negative territory for the first time since late January. Perhaps more significant for the global growth outlook is the strength of commodity prices given concerns over energy security and worries over supply disruptions. Brent now trades at $105/bbl, a gain of 8% since military action began, although prices had been rising ahead of then. Broadly markets are and will likely remain on edge until there is some clarity over where the situation is headed, which is very unclear.
Underlying the market movements is the recognition that the supply to global markets of major commodities, especially in Europe, is likely to be curtailed as a result. Energy is a key part of the story. Russia is, of course a major supplier of oil and gas to Europe (accounting for over a quarter of oil and over 40% of gas imports to the EU). And with natural gas the marginal fuel primarily used for power generation, it has a substantial indirect influence on electricity supply too. Even prior to the outbreak of war in Ukraine, gas prices had surged in Europe, to an unprecedented degree, as a result of a prolonged winter leading to low gas storage levels and disappointing power output from renewables last year. In the immediate future, it will be hard to replace any lost supply from Russia – either due to deliberate actions on the part of Russia, or as a voluntary consequence of sanctions imposed – with increased output from other sources, so it will also push up energy prices for European consumers and businesses. In an extreme case, power rationing for certain users could become necessary. In any event, there will be a hit to economic activity, and a rise in inflation, for Russia’s trading partners. Moreover, this effect is not limited to energy alone. Ukraine and Russia are major exporters of wheat to global markets, which stands to drive up food prices – also in some developing nations. And Russia is also a key exporter of other raw industrial materials such as nickel, and of fertilisers.
The situation is fast-moving and it is far from clear how it will evolve and how long it will persist.
Quantifying how large the effect of this on GDP is likely to be is fraught with extreme difficulties. Naturally, countries with deeper trade linkages and investment ties to Russia (and to Ukraine) look most exposed. The EU is particularly affected: Russia accounts for 4.1% and Ukraine for 1.2% of EU exports (imports: 5.6% and 1.0%, respectively). To put it into context, for the UK, corresponding figures are 0.7% and 0.1% (imports: 2.0% and 0.1%), and for the US, they are only 0.3% and 0.1% (imports: 0.9% and 0.1%). Reuters reported ECB chief economist Philip Lane to have presented three preliminary back-of-the-envelope calculations for the Eurozone to fellow Governing Council members on Thursday, said to be mostly based on commodity prices: a mild scenario of no impact (now deemed unlikely); a ‘middle scenario’ of a 0.3-0.4% hit; and a ‘severe scenario’ of a reduction of close to 1%.
The targeting of sanctions towards the financial system has raised some concerns over the potential spillover into other countries and markets. Certainly the potential tightening of credit conditions was a point raised when discussing SWIFT. Broadly amidst the nervous backdrop there has been a demand for USDs pushing up dollar funding costs as evidenced by movements in cross currency basis swaps. For example the cost of borrowing USD via Euro cross currency basis swaps reached 40bps, the most expensive since March 2020, although this has subsequently retreated to 24bps. However, it should be remembered that since the financial crisis, central bank tools have evolved to prevent a shortage of dollars globally. Notably the Federal Reserve has standing swap lines with the major central banks to help facilitate USD funding. In addition the Fed introduced the Foreign and International Monetary Authorities (FIMA) repo facility in March 2020 and allows other central banks and monetary authorities to raise dollar funding by repo-ing US Treasury securities with the New York Fed’s SOMA account. Taking these into account disruption in global dollar markets should be contained even amidst the current crisis. That being said, there are risks to banks such as those in Eastern Europe, which have typically had a closer relationship with Russia and will have a greater direct exposure.
Should financial contagion be avoided, the impact of the war on wider monetary policy settings naturally remains murky, given the uncertain magnitude and longevity of the hit to developed-market GDP and the boost to inflation. It is clear that, starting from the position of already uncomfortably high inflation, central banks had already begun, or were poised to begin, a tightening cycle. Evidently the greater inflationary pressure there is, the more urgent it is to address this. On the other hand, should GDP suffer noticeably and falling demand trigger rises in unemployment, this would reduce domestically generated inflation and lessen the need for monetary tightening. In these uncertain circumstances, we would expect central banks to place a particular premium on flexibility and optionality. As a result, our best guess is that they will proceed with tightening plans, but steer away from firm commitments that could tie their hands regarding future policy. This may lead markets to scale back their expectations of rate hikes further, for now.
At this stage, with so many uncertainties abounding, it is hard to present meaningful scenarios of how events could unfold. However, what is clear already is that, even in the best-case scenario of a swift end to the war, there is a shift in the tectonic plates geopolitically. This will also have major implications for certain sectors. Most obviously, sectors such as European defence have seen their outlook transformed. It appears equally clear that the momentum in the shift away from hydrocarbons as an energy source for the major developed economies, already underway owing to increasing efforts to limit climate change, will be reinforced further. This need not apply in the very immediate future; indeed, governments’ attempts to secure European energy supplies are likely to take precedence over climate goals: Italy, for instance, has indicated it may turn to coal or fuel oil should gas supplies be disrupted. And in the medium term, expanding LNG facilities will be a major priority too. But long-term, renewables stand to be a key beneficiary. Indeed, Germany has now indicated it aims to meet 100% of its energy needs through renewables by 2035, sooner than the target of ‘well before 2040’ set previously. The contours of the long-term future are starting to emerge. But the path to get there is uncertain and undoubtedly dangerous.
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